Börse Express – What is behind the major stock indices? (Andreas Schyra)

Equity indices have enjoyed increasing popularity and recognition as underlying assets for financial products for many years. Since indices are not tradable in themselves, but only represent a kind of barometer or statistical measure that is as representative as possible of an economy, industry or region, Exchange Traded Funds (ETFs) or certificates are used for replication in particular. It is therefore obsolete to copy the index manually by buying the individual members proportionally, which would also entail significantly higher transaction costs.

But an index is by no means the same as an index, because the differences in weighting and distribution of the index members play a large role in eventual investment success. The simplest way to form an index is weighting. Here, all members with the same share are included in the calculation. Weight shifts as a result of performance effects of the index members are reduced annually or semi-annually based on e.g. the index rules. A practical example of an equally weighted index is DivDAX.

Capital weighting based on a share’s free floating value.

Alternatively, indexes are often set up on a capitalization-weighted basis: each index member receives a share in proportion to its market value and the sum of the capitalization of all index members. In order to maintain trading liquidity, the shares’ free float or free float is used as a starting point. Several well-known indices such as the DAX, Euro STOXX 50 or MSCI World are weighted in their most familiar form of calculation using the free float market value. The inclusion of companies with a high market value results in a so-called market value bias.

Price weighting of index members.

There is also the variant of price weighting: Here, one share from each index company is taken into account in the calculation. For example, the Dow Jones Industrial Average follows this system. Shares with a “high” price are therefore weighted higher than shares with a “low” price. Among other reasons, share splits occur relatively frequently in the USA after significant price increases. On August 28, 2022, for example, Tesla carried out a one-for-three split, which meant that each shareholder subsequently had three times as many shares in their portfolio as before. However, the portfolio value of the Tesla position has remained unchanged as the share price has fallen by the same ratio. However, such transactions lead to a distortion of the index, which is referred to as downward bias.

Price versus performance index.

In principle, several indices are calculated in the form of a price and a performance index. Price index includes only index members’ price changes in performance. For performance indices, on the other hand, dividends or proceeds from subscription rights from capital increases are mathematically reinvested in the distributing share and therefore improve the performance of the index. DAX is calculated in both forms. However, much more attention is paid to the performance index, whereas the opposite is the case with, for example, the Euro STOXX 50.

The diversification possibilities of the indices are often limited.

The technical characteristics described should be taken into account when choosing an index investment, although the region, industry or economy in which the investment is to be made should be considered in advance. The diversification of the index also plays a role here: although the DAX no longer includes 30 but 40 companies, it cannot be diversified across countries due to its regional reference to the German economy. Every investor must decide for himself whether the Federal Republic is currently suitable as an investment focus.

Capitalization of the US stock market dominates the world.

A counterexample is MSCI World, which includes around 1,600 companies from 23 industrialized countries and reflects around 85 percent of their free float market value. The name of the index initially suggests a balanced, cross-regional diversification, which, however, must be limited. US companies account for about 70 percent of the index, followed by Japan with just 6 percent. A cumulative index share of around two percent is attributed to the more than 50 German companies included. However, this imbalance cannot be explained by the index rules alone, but rather is due to the fundamentally higher capitalization of many American companies, which significantly exceeds much of the rest of the world. Such an influence could only be changed by a maximum weighting of an economy.

Cap limit limits the maximum weight of individual index members.

In terms of sector, the picture is somewhat more balanced: the weighting varies between approximately three percent share of property companies and utility companies up to an IT dominance of just over 20 percent. But you look in vain for maximum weighting of sectors or countries in most indices. However, there are common ceilings, which often limit the weight of individual companies in the index to a value of ten percent.

Indices as passive vehicles in active portfolio management.

In order to enable a truly diversified portfolio and appropriate risk management, an active selection of the portfolio components is therefore advisable. In addition to individual stocks, ETFs are also suitable for developing a balanced allocation in active portfolio management to account for index targeting. The debate about whether an active or passive management style is superior seems fundamentally misguided because a combination of both techniques is advisable to use the best qualities from both worlds.

You can find this and other asset managers with opinions and investment strategies at www.v-check.de.

From Börse Express PDF from 23.09. here to download

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